The merger between BP and Amoco seeks to create a third “super major” in the oil industry. Is size really so important?

DISMISSIVELY, John D. Rockefeller once referred to the early days of the American oil industry as “harvest time”: anybody could get rich simply by digging a hole in the ground. His generation, he maintained, lived through harsher times, and got rich through their organisational flair, or not at all. He turned his genius to consolidation, and it made him very rich indeed.

With the price of Brent Crude at its lowest level in real terms for 25 years, harsh times are here again—and so, it appears, is the Rockefeller vision. The biggest industrial merger ever, between British Petroleum and Amoco, may herald a new era of consolidation in an industry where mergers have been scarce of late.

BP, whose American wing is based around the Ohio part of Rockefeller's Standard Oil empire, is paying $48 billion to acquire Amoco, which was created from Standard Oil of Indiana. Although this represents a steepish 15% premium over Amoco's pre-bid value, the merger has been applauded as a good fit: BP is generally better at the upstream part of the business (finding and extracting oil); Amoco at the downstream business of refining, distributing and marketing the stuff. Amoco's stronghold is the United States—hitherto a weak spot for BP. And the Chicago-based firm beefs up BP's gas and petrochemicals divisions.

As these empires are meshed together, there should be plenty of savings. Sir John Browne, BP's boss, who will also head the new company, has a flair for cutting costs that Rockefeller might have appreciated: BP's workforce now has fewer than half the 112,000 people it had in 1992. Some 6,000 of the 99,000 jobs at the new BP Amoco are already earmarked to go; managers' bonuses will be tied to producing $2 billion in annual pre-tax savings by the end of 2000. Businesses that are not number one or two in their segments are likely to be sold.

All the same, Sir John promises much more than mere cost-cutting. He describes both BP and Amoco as being “at the top of the second division”. The deal will put the new BP Amoco in a first division of “super majors”, alongside Exxon and Royal Dutch/Shell. The new firm will on some counts be these firms' equal: it will, for instance, have more oil and gas reserves than Exxon. More important, the merger puts BP in a different league from all the other companies in the business.

As a competitive tactic, this has already worked well. The oil industry is now abuzz with gossip about further consolidation involving BP's former peers, such as Chevron, Mobil and Texaco. BP's bosses even speculate that the news may have caused a frisson of pain in Shell House, where its old enemy had been concentrating on overtaking Exxon. Yet the question of whether the oil industry is charging in the right direction remains unanswered.

With stocks of oil at record levels, demand depressed in Asia, and members of the OPEC oil cartel always ready to cheat on their quotas, there is little hope of a dramatic rise in the oil price in the near future. Having been hustled out of the Middle East long ago, all the majors are heavily dependent on giant fields that were discovered decades ago, many of which (particularly those in North America and Europe) are starting to decline.

The great task for today's oil firms is to replace these “crown jewels”. In recent years a mere handful of fields containing more than 500m barrels have been discovered, in contrast with dozens of big new discoveries in previous decades. Deep-water reserves, such as those in the Gulf of Mexico and off the coast of West Africa, are expensive to extract. Russia, which sits on 5% of the world's proven oil reserves, is prickly. Last year BP took a 10% stake in Russia's Sidanco; it recently reported a $20m loss due to problems there. The Caspian, where both BP and Amoco have struck deals, is stuck in a tortuous geopolitical argument over the route of pipelines from the area.

The benefits of being big

Admittedly there is natural gas: demand for the stuff is growing more rapidly than demand for oil, in part because burning it produces less pollution. Amoco has large reserves of gas. In 1988 it bought Dome Petroleum, a Canadian gas firm, for $4.2 billion. But transporting gas is difficult and it has no international spot market, forcing producers to find long-term buyers before any big investment in a gas field, which can be a long process.

BP thinks the merger will help it deal with these difficulties. Simply by having a broader range of countries, it should be less vulnerable than most to upsets in any one place: Shell's problems in Nigeria made only a small dent in its performance. “Your appetite for risk is a function of how much capital you have,” one senior figure stresses. “Now we can afford to make bigger bets.” Both BP and Amoco have often had to go into partnership on big oil deals; now they can bid alone. There is also a growing tendency by governments to demand that oil companies do more than just extract oil; they have to build infrastructure as well—once again pushing up the cost. BP and Amoco also say that they will reconsider the liquefied natural gas industry that they have shied away from in the past.

In all this, Sir John is careful to talk about size being an “outcome, not an aim” and stresses his willingness to sell businesses as well as enter them. He is adamant, however, that scale does matter in some areas—and even in the fashionable business of knowledge. He claims that BP's profit growth has partly stemmed from transferring expertise (in drilling technology, for instance) around the company; now these skills, built at great expense, can be put to work across a much wider group at little extra cost. The same logic would presumably apply to Amoco's flair for retailing.

This is an intriguing vision. But the case for size and creativity within a super major remains unproven. BP's return on capital employed—the main benchmark of profitability amongst big oil firms—was 14% in the 12 months to the end of June, well above Shell's figure of 10% (Amoco scored even lower at 9%). Shell is even now starting a restructuring drive that may clamp back on investment. As for Exxon, its 14.5% return has been achieved more by returning its capital to investors through share buybacks than by using it to grow bigger.

Moreover, the oil industry's future may turn on two things where nimbleness may count for more than size. The first is the long-awaited introduction of other forms of energy—a development where large reserves of oil may actually prove a handicap. The other, more immediate possibility is the re-entry of western firms to the Middle East. This is the real prize in the oil industry, both because of the Middle East's reserves and because it still costs less than $2 a barrel to extract oil there.

Moreover, while OPEC, which is dominated by Middle Eastern producers, owns three-quarters of the world's proven reserves (see chart), it currently produces only 41% of the world's annual oil supply. This means that as non-OPEC supplies begin to dwindle, or are made uncompetitive because of the low oil price, the importance of the Middle East is likely to grow.

So far, winning deals in the Middle East seems to depend in larger part on the political astuteness and lobbying skills of oil bosses than on the size of their capital base. French oil firms, such as Total and Elf, have had a head-start in negotiating deals in Iran and Iraq because their government is more friendly to these regimes. As Rockefeller discovered, even the best-organised oil firms can be undermined by politicking.